Portfolios of the Poor:
How the World's Poor Live on $2 a Day

Daryl Collins, Jonathan Morduch, Stuart Rutherford + Orlanda Ruthven

A common picture of finance for the very poor involves moneylenders
charging extortionate interest rates, perhaps with "white knight"
microfinance organisations riding to the rescue. The reality is rather
different. Poor people spend a significant amount of time managing money
and use a wide range of financial instruments for a variety of ends.
While their choices may not be optimal, apparently inefficient financial
decisions often make sense on closer inspection.

Portfolios of the Poor is based on the analysis of financial diaries,
tracking every financial transaction of individual households, taken from
studies between 1999 and 2005 in rural and urban areas of Bangladesh,
India, and South Africa. The authors are honest about the number of
diaries — some 250 in total — being too small to support statistical
analysis, but they are a broad enough sample to give a feel for what is
going on and some guidance for policy-makers or financial operators.
A strength of the approach is that it is "bottom up", starting with
how people actually live, and not narrowly focused on the evaluation of
interventions. (The opening chapter covers the background to the studies;
it is supplemented by an appendix with more methodological details.)

No one actually receives $2 a day. Even those among the South
African diarists with government grants had those paid monthly,
"regular" employment is similarly lumpy and not always that regular,
and casual employment and agricultural harvests are highly variable.
So a central role for finance is in smoothing out income fluctuations
to ensure that there is enough money to provide food and other basic
requirements on a daily basis. To this end households use savings
and borrowings simultaneously, mixing informal, interest free loans
from friends and family, wage advances and rent arrears, semi-formal
(microfinance) loans, and in occasional cases formal (bank) services.
Here the cash flow analysis captures what matters, not the balance-sheet.

Finance is important for dealing with risks. Health problems are the
most common source of unpredictable large demands, but funerals in South
Africa are extremely expensive; these are funded using a combination
of contributions from relatives, formal funeral plans and informal
burial societies, which almost always needs to be supplemented with
loans. General purpose loans are more flexible than insurance tied to
particular risks, but there's clearly an unmet demand for insurance.
The most obvious problem here is in trust, with concerns about the
possible failure of insurers and moral hazard on the part of the insured
exacerbated by the social divide between them.

Large sums are also needed for special occasions such as weddings and for
opportunities such as purchasing land, starting a business or furthering
education. This involves both borrowing, usually from multiple sources,
and the use of savings "accumulators". Among the most sophisticated
tools here are auction Rotating Savings and Credit Associations, where
participants bid for use of the accumulated money, allowing savers and
borrowers to negotiate an effective interest rate without middlemen or
sophisticated accounting; these "could be considered the world's most
efficient intermediation system".

With financial instruments for the wealthy the price of money —
an interest rate or a rate of return — is central. The headline
interest rates on some loans for the poor can look completely insane, but
annualised interest rates don't make sense for loans of short duration,
where charges are better seen as fees. And in practice interest is often
not compounded or is waived after some period, or forbearance of other
kinds is exercised. Apparently negative interest rates on savings can
also be deceptive. One example highlighted is a "collector" who takes
20c a day from women for 220 days and then gives them back $40 at the end.
This cycle has repeated so many times that it is no longer clear whether
this is a loan or a savings plan. The convenience, flexibility and
reliability of financial instruments are often more important concerns
than their interest rates.

A later study, using the same diary methodology, was carried out on
"Grameen II" households in Bangladesh, attempting to evaluate changes
Grameen Bank made in 2001 to its microfinance products. This involved
more flexible loans which could be "topped up" before completion of
their term, a passbook savings account designed to make management of
cash flows easier, and a long-term savings product that allowed access.

This leads into some suggestions for ways in which microfinance could
be improved. There's demand for a cash-flow management facility that
combines the ability to make small savings of any size at any time
with loans of modest value that can be accessed quickly. There may be
ways to replicate the best features of informal savings clubs but to
improve on their reliability. And there's a space for the provision
of general-purpose loans, not restricted to microenterprise as many
microfinance loans have been. Products need to be reliable, convenient,
flexible and have structure — regularities that promote self-discipline.

This analysis is heavily illustrated with examples from individual
households. In addition, a second appendix presents summaries of fifteen
of the portfolios, with a page describing each household facing another
giving its financial net worth breakdown at the beginning and end of the
study year, along with its turnover in each kind of financial instrument.
This detail helps to give a feel for the way financial concerns are
interlocked with the broader course of people's lives, rather than being
abstract problems.

Though slightly more sophisticated terms like "debt-to-equity"
occasionally occur in Portfolios of the Poor, no real knowledge of
finance is assumed, just the ability to read a basic balance sheet or
cash-flow breakdown. It might have been worthwhile including a brief
explanation of this, however, since there are plenty of well-off people
in developed countries whose understanding of finance may not go even
that far. (A similarly detailed study of the finances of poor households
in say the United Kingdom would make an interesting comparison.)

The authors of Portfolios of the Poor don't pretend that microfinance
is a magic cure for poverty and don't claim that any particular financial
instrument or service is going to have revolutionary effects. They do
make a convincing case both for the importance of finance in the lives of
the extremely poor and for there being room to improve the provision of
financial services to them.